An Economic Perspective on the Natural Resource Curse and Its Implications for a Developing Country Jeffrey Frankel Harpel Professor of Capital Formation.

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Presentation on theme: "An Economic Perspective on the Natural Resource Curse and Its Implications for a Developing Country Jeffrey Frankel Harpel Professor of Capital Formation."— Presentation transcript:

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An Economic Perspective on the Natural Resource Curse and Its Implications for a Developing Country Jeffrey Frankel Harpel Professor of Capital Formation and Growth Harvard University Day of Ecuador at Harvard: Breaking the Natural Resources Dependence: Is It Possible? A Vision from the Middle of the World Monday, April 21, 2014, 9:00am to 4:30pm

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Many countries that are richly endowed with oil, minerals, or fertile land have failed to grow more rapidly than those without. Example: Some studies find a negative effect of oil in particular, on economic performance. The Natural Resource Curse

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6 Are natural resources necessarily bad? Commodity wealth need not necessarily lead to inferior economic or political development. Rather, it is a double-edged sword, with both benefits and dangers. – It can be used for ill as easily as for good. The priority should be on identifying ways to sidestep the pitfalls that have afflicted commodity producers in the past, to find the path of success. No, of course not.

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7 Some developing countries have avoided the pitfalls of commodity wealth. – E.g., Chile (copper) – Botswana (diamonds) Some of their innovations are worth emulating. I will suggest some policies & institutional innovations to avoid the curse, especially ways of dealing with price swings.

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4. Monetary policy: Try Nominal GDP Targeting, as an alternative to the popular CPI-targeting. 5. Fiscal policy: Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent commodity price rises. With non-political determination of “permanent” vs. “temporary.” 6 recommendations for commodity producers continued Countercyclical macroeconomic policy In the past, policy has often been procyclical.

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6 recommendations for commodity producers, concluded Good governance institutions 6) Professional management of wealth funds Norway’s Pension Fund – All govt. oil revenues go into it. – Govt. (on average over the cycle) can spend expected real return, 4%. – All invested abroad. Reasons: ( 1) for diversification, (2) to avoid cronyism in investments. But also insulate it from politics, – like Botswana’s Pula Fund, for financial optimization, not social objectives.

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Unsuccessful policies, continued 2) Price controls to “stabilize” prices at low levels Often the goal of controls is to shield consumers of staple foods & fuel from price increases. But the artificially suppressed price discourages domestic investment & production, and requires rationing to domestic households. – Shortages & long lines can fuel political rage as well as higher prices can, – not to mention when the government is forced by huge gaps to raise prices discontinuously. Price controls can also require imports, to satisfy excess demand. » exacerbating a world price spike even more.

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Source: IEA Few fossil fuel subsidies actually go to the poor, typical of subsidies adopted in the name of equality.

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Unsuccessful policies, continued 3) Some African countries adopted commodity marketing boards for coffee & cocoa around the time of independence. The original rationale: to buy the crop in years of excess supply, sell in years of excess demand. In practice the price paid to cocoa & coffee farmers was always below the world price. – As a result, production fell.

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A G20 initiative deserved to succeed: Producers & consuming countries in grain markets should cooperatively agree to refrain from export controls and price controls. – The result would be lower world price volatility.

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An initiative that has less merit: 5) Attempts to blame speculation for volatility – and so to ban derivatives markets. Yes, prices are sometimes hit by speculative bubbles. But in commodity markets – prices are more often the signal for fundamentals. Don’t shoot the messenger. – Also, derivatives are useful for hedgers.

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The overall lesson for microeconomic policy Attempts to prevent commodity prices from fluctuating generally fail. Even though enacted in the name of reducing volatility & income inequality, their effect is often different. Better to accept volatility and cope with it. When the aim is poverty alleviation, use well-targeted programs instead, – Conditional Cash Transfers along the lines of Oportunidades (Mexico) or Bolsa Familia (Brazil).

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“Resource nationalism ” continued 8) Keeping out foreign companies altogether. – But often they have the needed technical expertise. – Examples: declining oil production in Mexico & Venezuela. 9) Going around “locking up” resource supplies. – China must think that this strategy will protect it in case of a commodity price shock. – But global commodity markets are increasingly integrated. If conflict in the Persian Gulf doubles world oil prices, the effect will be pretty much the same for those who buy on the spot market and those who have bilateral arrangements.

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More Appendices Elaboration on proposals to reduce the pro-cyclicality of macroeconomic policy II) To make monetary policy less procyclical: Nominal GDP targeting or P roduct P rice T argeting III) To make fiscal policy less procyclical: emulate Chile. PPT

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Demand vs. supply shocks An old wisdom regarding the source of shocks: – Fixed rates work best if shocks are mostly internal demand shocks (especially monetary); – floating rates work best if shocks tend to be supply shocks (especially external terms of trade). One set of supply shocks: natural disasters – R.Ramcharan (2007) finds floating works better. The most important category: trade shocks Currency regime, continued

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30 If the exchange rate is not to be the monetary anchor, what is? The popular choice of last decade: Inflation Targeting. – But CPI target can react perversely to supply shocks & terms of trade shocks.

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P roduct P rice T argeting : Target an index of domestic production prices [1] such as the GDP deflator Include export commodities in the index and exclude import commodities, so money tightens & the currency appreciates when world prices of export commodities rise accommodating the terms of trade -- not when world prices of import commodities rise. The CPI does it backwards: It calls for appreciation when import prices rise, not when export prices rise ! [1] Frankel (2011, 2012). PPT

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34 Why is PPT better than a fixed exchange rate for countries with volatile export prices? If the $ price of the export commodity goes up, the currency automatically appreciates, – moderating the boom. If the $ price of export commodity goes down, the currency automatically depreciates, – moderating the downturn – & improving the balance of payments. PPT

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35 Why is PPT better than CPI-targeting for countries with volatile terms of trade ? If the $ price of imported commodity goes up, CPI target says to tighten monetary policy enough to appreciate the currency. – Wrong response. (E.g., oil-importers in 2007-08.) – PPT does not have this flaw. If the $ price of the export commodity goes up, PPT says to tighten money enough to appreciate. – Right response. (E.g., Gulf currencies in 2007-08.) – CPI targeting does not have this advantage. PPT

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III) Achieving counter-cyclical fiscal policy 1 st rule – Governments must set a fiscal target, set = 0 in 2008 under President Bachelet. 2 nd rule – The fiscal target is structural: Deficits allowed only to the extent that – (1) output falls short of trend, in a recession, – (2) or the price of copper is below its trend. 3 rd rule – The trends are projected by 2 panels of independent experts, outside the political process. – Result: Chile avoids the pattern of 32 other governments, where forecasts in booms are biased toward over-optimism. – Chile ran surpluses in the 2003-07 boom, while the U.S. & Europe failed to do so. Chile’s budget institutions (adopted, 2000; formalized in law, 2006)

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Chile ’ s fiscal position strengthened immediately: – Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005 – allowing national saving to rise from 21 % to 24 %. Government debt fell sharply as a share of GDP and the sovereign spread gradually declined. By 2006, Chile achieved a sovereign debt rating of A, several notches ahead of Latin American peers. By 2007 it had become a net creditor. By 2010, Chile ’ s sovereign rating had climbed to A+, ahead of some advanced countries. => It was able to respond to the 2008-09 recession – via fiscal expansion. The Pay-off

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IV: An example of commodity speculation In the 1955 movie version of East of Eden, the legendary James Dean plays Cal. Like Cain in Genesis, he competes with his brother for the love of his father. Cal “goes long” in the market for beans, in anticipation of a rise in demand if the US enters WWI.

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An example of commodity speculation, cont. Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father, a moralizing patriarch. But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and tells him he will have to “give the money back.”

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Cal has been the agent of Adam Smith ’ s famous invisible hand: – By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, – thereby increasing the supply so that more is available precisely when needed (by the Army). The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to see. An example of commodity speculation, cont.

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42 42 How could abundance of commodity wealth be a curse? What is the mechanism for this counter-intuitive relationship? At least 5 categories of explanations. Appendix V: Channels of the Natural Resource Curse

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44 Commodity prices have been especially volatile over the last decade. Source: UNCTAD 1. Volatility in global commodity prices.

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45 2. Natural resources may crowd out manufacturing, and manufacturing could be the sector that experiences learning-by-doing – or dynamic productivity gains from spillover. So commodities could in theory be a dead-end sector. My own view: a country need not repress the commodity sector to develop the manufacturing sector. – It can foster growth in both sectors.

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49 49 The Dutch Disease: 5 side-effects of a commodity boom 1) A real appreciation in the currency 2) A rise in government spending 3) A rise in non-traded goods prices 4) A resultant shift of production out of manufactured goods 5) Sometimes debt.

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50 The Natural Resource Curse should not be interpreted as a rule that commodity-rich countries are doomed to fail. The question is what policies to adopt – to avoid the pitfalls and improve the chances of prosperity. A wide variety of measures have been tried. A wide variety of measures have been tried. Some work better than others. Some work better than others.